Q3 2016 Market Report

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Executive Summary   

Economy

  • Economic uncertainty associated with an unprecedented presidential election cycle will continue after new administration moves in due to ongoing discontent between parties. 
  • U.S. energy sector has likely bottomed out; real signs of recovery have emerged over past the quarter, such as increases in rig counts.  
  • Gross domestic product (GDP) is anticipated to be 1.4% for 2016 and 2.0% for 2017, both slower than 2.5% in 2015.  
  • U.S. employment remains steady, posting 156,000 new jobs in September, after 167,000 in August. Job growth below 200,000 per month suggests tightening labor market. 
  • Houston technically entered an economic recession in November 2015; while the bottom has likely passed, Houston is not yet recovering.  
  • Houston’s economic outlook is to shift from a modestly negative stance to one that is generally flat for the remainder of 2016. 

Office Market 

  • Houston’s office real estate continues its falling phase of the market cycle with reduced demand and low leasing activity.
  • Q3 2016 posted -235,000 sq. ft. of negative net absorption, a demand for office space that is lower than average historic Q3 performance of 541,000 sq. ft. 
  • Leasing activity of 3.1 million sq. ft. was less than historic Q3 activity of 4.4 million sq. ft.  
  • Vacancy continued its climb, now up to 15.8%, with availability at 22% driven largely by 12.1 million sq. ft. of sublease space. 
  • Construction continues its decline from 17 million sq. ft. in 2014 to under four million sq. ft. today. 
  • Sublease base asking rents for Class A buildings are 35% lower than direct base asking rents, the largest percent difference seen over the past 17 years. 
  • The Class B market has softened but with only a 22.8% difference between direct and sublease base asking rents. 
  • Houston’s Class B market is helping to stabilize the more dramatic downturn in Class A buildings.

 

2016-Q3-Hou-industrial-Fig1

Table 1


Broker's Perspective

    The office market is in a significant decline and everyone is searching for the “bottom”. Tenants are being cautious and are trying to figure out when would be the best time to act, while landlords are offering increased concessions as they try to figure out how best to compete with the massive volume of sublease space now on the market. With such volumes of sublease space, deals are only getting cheaper as tenants vie to rid themselves of this excess space.

    In my opinion, we cannot begin to talk about a bottom until the volume of sublease space flattens out and starts to decrease. The good news is that in October for the first time since late 2014, we did not see any increase in the percent of availability that is sublease space. This could be the start of a trend reversal and a bottoming out of the market or it could be a temporary pause. Only time will tell.

    In the interim, we are seeing landlords heavily discounting deals primarily through the use of free rent which in some cases has been as much as 18 months free on a 10-year lease term. This is somewhat submarket specific, with the west Houston energy corridor being the hardest hit submarket. However, in the past couple of quarters we have seen some significant deterioration in other submarkets, including Downtown and the Galleria, both of which had been slower to feel the impact of Houston’s overall soft market.

    The energy business appears to been bottoming out as oil prices seem to have stabilized and producers and service companies have adjusted to the lower price environment. I do not expect to see a sharp increase in activity in the next 12 to 24 months, but we are already seeing signs of improvement (e.g., increases in rig counts) which bodes well for the office market, and is further indication that we could be starting to see a bottom across the board.

    I expect the first half of 2017 to be a solid bottoming out in the office market with some improvement in the second half of the 2017. Unless the energy business experiences a significant upswing, I do not expect a rapid recovery in the office market. I think we are in for a two- to four-year slow recovery back to a stabilized office market.

Jon Silberman
Managing Partner
NAI Partners


Economic Overview

National Economy

    With a truly unprecedented election cycle and associated economic uncertainty coming closer to an end, discontent between parties will still likely hang over policy and decision makers as a new administration takes hold. Gross domestic product (GDP) is anticipated to be 1.4% for 2016 and 2.0% for 2017, both slower than 2.5% in 2015. GDP is being led by consumer spending and job gains, but weak business, government spending, and slow export sales are holding it back. Consumer spending increased strongly by 4.3% in Q2. Revolving consumer credit continued its slow but steady increase, with August showing the largest increase in 2016. Consumer interest rates remained steady. The Consumer Sentiment index moved higher in September, rising 1.4 points to 91.2, most of which came from higher income households. 

    Employment continues to remain steady. September posted a solid 156,000 new jobs, following 167,000 new jobs in August. Job growth remaining below 200,000 per month is suggestive of a tightening labor market. As more people entered the labor force, unemployment moved up to 5%, which historically has been considered full employment in the labor force. Also, wage growth increased by 2.6% in September, following 2.4% in August. Some analyses still suggest that the recovery is weak and as a result interest rates may stay low. With strong September job growth, and two more job reports to go, the December FOMC meeting following the election will likely result in an interest rate hike by year’s end. Nevertheless, interest rates are expected to remain low and fluctuate within a small range.

    International trade continues to see slow export sales. U.S. exports are down 3.7% YoY. Yet, the negative economic impacts of falling import prices is beginning to fade, as import prices inched up 0.1% in September and are only down 1.1% relative to this time last year. The trade deficit widened modestly in August, but realized net exports are likely to make a positive contribution to GDP in Q3. Demand for U.S.-made durable goods abroad will remain weak and flat through the end of the year and increase modestly by 3-4% in 2017. These trends may stifle U.S. business investment.

    The Small Business Optimism Index of the National Federation of Independent Businesses (NFIB) continued its decrease over the past 12-18 months, declining 0.3% points in September to 94.1, but remaining unchanged relative to the past six-month average. This indicates businesses are cautious on hiring and inventories. While factory orders of durable and nondurable goods rose in Q3, business investment in capital goods fell, which signaled a softer quarter. In September the ISM manufacturing index bounced firmly back into expansion territory at 51.5. 

    The U.S. energy sector appears to have bottomed out, and over the past quarter or so has begun to show real signs of recovery, with consistent weekly increases in rig counts being led by the Permian Basin. Nevertheless, modest increases in drilling activity and oil production does not signal the end of the persistent oversupply and large stockpiles. Recently, the Organization of the Petroleum Exporting Countries (OPEC) has agreed to agree to cut production at the next OPEC meeting, but when it still remains unclear when the global rebalance of the oil market will occur. 

    More people are looking to buy homes, but home availability remains low, driving up prices. Residential housing for August, in terms of sales of both new and existing homes fell, and new housing starts declined as well. Yet, this is in the context of a strong first half of 2016 where home sales and new home construction were very strong through July 2016. The Dodge Momentum Index of non-residential construction declined 4.3 percent in September to 129, but is up 5.1% YoY. Both July and August saw pullbacks in total construction momentum across residential, nonresidential, and public spending. 

Houston and Texas Economy

    After adjusting for price effects, the Houston metropolitan area’s GDP grew 4.6% from 2014 to 2015. Texas and Houston continue to have a mixed set of economic numbers, but all indications are that the bottom has come and we are now moving up. Rig count has increased every week for 15 of the past 16 weeks. Technically, Houston did move into an economic recession in November of 2015; while the bottom has likely come and gone, Houston is not yet recovering. The outlook for Houston is to shift from a modestly negative economic stance to one that is generally flat for the remainder of 2016. 

    Employment in Texas grew 2.6% in August and 3.2% in July, with an annualized increase of 0.8% for 2016 thus far. The employment forecast for Texas is 1.2% in 2016. Jobs in Houston grew 1.8% over June, July, and August, the best seen since early 2015. Job growth remains low in the oil and oil service fields, while growth was seen in leisure and hospitality, private education and health services and government, and then trade, transportation, and utilities. This is all in the context of annualized -1.0% decline in employment of about 15,000 jobs year to date. Unemployment was 4.7% in Texas. 

    The revenue index of the Texas Service Sector Outlook survey increased from 6.5 to 13.0 in September. Meanwhile the sales index of the Texas Retail Outlook Survey increased from -5.3 to 2.0. Factory activity in Texas did increase substantially in September, according to the Texas Manufacturing Outlook Survey. The index which measures manufacturing conditions rose 12 points to 16.7, again a substantial increase. Nevertheless, consistent with the broader U.S. economy, business conditions in Texas are mixed. The general business activity index continued into negative territory for another month at -3.7, representing almost two years in negative territory. The Houston Business Cycle Index grew 2.6% in August, following 2.0% and 2.6% in July and June, respectively. Annually, however, the index is down 2.2% YoY. Texas exports declined 7% in July, the largest drop seen since 2009. 


Market Overview

Net Absorption

    Demand, as measured by net absorption (direct plus sublease space), is the change in occupied stock inventory. Figure 2 shows net absorption since 2000 by year and quarter for combined Class A and B office space. Following 1.7 million sq. ft. of positive net absorption in Q1 2016, the second quarter had about -100,000 sq. ft. of negative net absorption. The third quarter had -235,000 sq. ft. of negative net absorption, representing a substantial decrease of -139% QoQ and -126% YoY (Table 1). The historic Q3 average (± 95% confidence interval) for net absorption is 541,164 sq. ft. (± 569,186). We are 95% certain that Q3 net absorption typically falls between -28,021 and 1,110,350 sq. ft. Thus, a negative net absorption of -235,209 sq. ft. in Q3 2016 is significantly below historic Q3 performance. 

Leasing Activity

    Leasing activity is another measure of demand for office space, representing the total amount of space for direct leases, subleases, renewals, and pre-leasing. Figure 3 shows leasing activity since 2000 by year and quarter for combined Class A and B office space. The third quarters 3.12 million sq. ft. of leasing activity represented decreases of -7.2% QoQ and -23.6% YoY (Table 1). The historic Q3 average (± 95% confidence interval) for leasing activity is 4.41 million sq. ft. (± 575,924). We are 95% certain that Q3 leasing activity typically falls between 3,837,835 - 4,989,683 sq. ft. This indicates that current leasing activity is statistically lower than historic Q3 measures. With net absorption lagging behind leasing activity, lower leasing activity in Q3 suggests low absorption in quarters to come. 

Availability and Vacancy

    Vacancy and availability measure both the supply and demand of office space, and as such are key indicators of shifts in the phase of the office market cycle. Availability better measures total supply because it includes vacant, occupied, and sublease space. Vacancy better measures empty space on the market, whether or not that space is leased or for rent. Overall, the office market weakened in Q3 2016, as both vacancy and availability continued to increase through the falling phase of the office market cycle that began in mid-2014 (prior to the manifestation of the oil downturn) (Figure 4). For Class A and B buildings combined, availability was 21.7%, up 4.3% QoQ and 16.7% YoY (Table 1). Likewise, vacancy climbed to 15.8%, up 4.0% QoQ and 17.0% YoY (Table 1). 

Figure 2

Asking Rent

   Figure 5 plots both gross and base (NNN) asking rents for direct and sublease space since 2000 for Class A and B buildings. Despite limitations of asking (rather than actual) rent, we can derive information on market conditions by examining the difference between direct and sublease base rents. The greater the difference between direct and sublease asking rents, the softer are market conditions.

   Since Houston’s office market began falling in late 2014, the difference between direct and sublease base asking rents for Class A buildings has grown from $3.77 to $8.52 (Figure 5B). Historically, Class A buildings have shown an average of $3.52 difference between direct and sublease base asking rents, with a 95% confidence interval of $3.15 to $3.89. At the current $8.52, Houston’s Class A rents are way outside this expected range. For Class B buildings, the difference between direct and sublease base asking rents has grown from $0.82 to $4.29 since 2014 (Figure 5B). Historically, Class B buildings have shown an average of $1.97 difference between direct and sublease base asking rents, with a 95% confidence interval of $1.62 to $2.21. At the current $4.29 difference, Houston’s Class B rents are outside of this range.

Figure 3

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Construction and Deliveries

   Construction of new stock inventory shapes the growing supply of office space. “RBA Delivered” refers to completed construction, while “RBA Under Construction” refers to space under construction that has not yet been completed. Figure 6 breaks down deliveries and construction on an annual basis by Class A and Class B products. Deliveries in Q3 2016 were 1.7 million sq. ft. of Class A and B buildings, a decrease of 31% QoQ but an increase of 44% YoY (Table 1). RBA under construction is now below four million square feet in Q3 2016, a decrease of -16.8% QoQ and -65.6% YoY (Table 1).

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Inventory

   Figure 7 depicts changes in the inventory of Class A and Class B buildings since 2000, both in terms of RBA and the number of buildings. Stock inventory for Class A and B office space included 274 million sq. ft. for 3,961 buildings (Table 1).

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Methodology

   The quarterly report for the office market includes information and data for Class A and Class B buildings, but excludes Class C buildings. Buildings are not excluded on the basis of single vs. multi-tenancy, owner occupancy, or building size.

 

Information and data within this report were obtained from sources deemed to be reliable. No warranty or representation is made to guarantee its accuracy.  Sources include:  U.S. Bureau of Economic Analysis, CoStar, Council on Foreign Relations, Federal Reserve Bank of Dallas, Greater Houston Partnership, FiveThirtyEight.com, Houston Association of Realtors, Moody Analytics, NAI Global, National Association Realtors, Texas A&M Real Estate Center, Well’s Fargo, University of Houston’s Institute of Regional Forecasting, U.S. Bureau of Labor Statistics.



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Resources

I-35 Corridor Activity Map

The New #CREcosystem Refresh - featuring contributions from Larry Koestler, VP of Marketing